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A Solid Third Quarter for Intel

TOWACO, NJ (Oct. 13, 1999) -- Judging by the initial reaction in after-hours trading, the sky must have been falling on Intel (Nasdaq: INTC) after it released earnings last night. After all, our Rule Making company had the nerve to miss the published earnings estimates of the Wise by two cents. Even worse, it missed the so-called whisper number by a nickel. Look out below. Barron's was right -- Intel is overvalued. Better sell your shares now and ask questions later.

If you approach the market with a short-term perspective, you might have had thoughts like those after reading Intel's earnings release. However, as an Intel investor with a Rule Maker approach, I'm quite content with this quarter's results. Intel's strong financial statements confirm that the business is still intact. Like here in Rule Maker Land, the Drip Portfolio -- in last night's Drip Report -- also took a positive long-term perspective on Intel's earnings.

Even under the microscope of our Rule Maker Ranker spreadsheet (linked at bottom), it's hard to find fault with Intel's quarter. Fellow Fool TMF Tribe -- who must have the fastest spreadsheets in the West -- cranked Intel's results through the Ranker before I had a chance to do it myself. Intel posted its highest score to date, an impressive 54 out of 61, which places it in the elite top tier of all Rule Makers. To see how the scoring stacked up, check out Intel's RM ranking. (By the way, our RM Master List now includes the rankings of nearly 100 companies. That list is posted monthly, and is available via a permanent link that resides below messages on the Rule Maker Companies board.)

What I'd like to do next is take you through the numbers for a firsthand look at how Intel's business fared during the quarter. Per the usual, we'll look at the five financial criteria that we consider most important to Rule Maker investors. My comments will be based upon both the material found in the press release as well as Intel's earnings conference call (linked at bottom).

Sales Growth of at Least 10% -- Unfortunately, Intel fell a little bit short of this guideline. In absolute terms, sales grew by 9% over the same quarter a year ago. If you exclude the impact of the two most significant acquisitions that closed during the quarter (Dialogic and Level One), sales grew only 7%. Even so, sales growth was stronger than Intel had predicted during its second quarter conference call. The one disappointment here was that although Q3 sales volume reached record levels, there was a further decline in the average selling price (ASP) of its products. The rate of price decline was slower than in previous quarters, but it still had an impact on revenues. This is the most likely reason that revenues fell about 3% short of the expectations of the Wise.

There were a couple of reasons given for the decline in ASP. One was that Intel gained additional share in the value PC section of the processor market by selling more Celeron chips. Additionally, there were some delays in ramping up its 0.18 micron processors. This had a negative impact on Intel's ability to make and sell high-end processors. There were also some glitches related to a flaw in its Xeon chips. All of these occurrences are disappointing but not unexpected in an environment where a company is regularly cannibalizing its product line by introducing new and improved products. Eventually, these changes will have a positive impact on Intel's gross margins.

On a geographic basis, demand in all regions and business segments remained strong. In the Asia Pacific region, China and Korea saw increased demand, while Taiwan was strong as well. In Europe, Intel benefited from a stabilization of PC prices and a strong retail market. Pentium III processors represented 50% of retail sales for all of Europe. Japan was the only region in which third quarter sales were less than those in the second quarter. However, it is believed that Internet-related PC demand should lead to improvement in Japan. The Americas are on track for seasonal second-half growth as well.

One of the most interesting things that I learned on the call was some additional detail about Intel's revenue recognition policy. As you may know, Intel often sells products through distributors. I was quite happy to learn that Intel does not recognize revenues related to these products until the distributors ship them to the end user. This conservative way of recognizing sales is music to this Fool's ears.

Gross Margins of at Least 50% -- Intel's gross margins for the quarter rang in at 59%, which was essentially flat with the prior quarter's results. However, it was up strongly from the 53% figure in the third quarter of 1998. During the conference call, Intel said that it expected gross margins to increase by about two percentage points during the fourth quarter. Interestingly enough, as happened one other time in the past, Intel's gross margins for the quarter were also hurt by the fact that its 0.18 micron manufacturing process is more efficient than expected. This means that its cost of goods sold is lower, which places a lower carrying value on the inventory found on its balance sheet. The good news is that when the products are sold in the future, Intel will realize more profit on their sale. Hence, the expected uptick in margins in the future.

Net Margins Greater Than 7% -- Intel reported a robust net margin of 26%, which is essentially flat when compared to last quarter, but an impressive six-percentage-point improvement over the third quarter of last year.

Cash-to-Debt Ratio of at Least 1.5 -- Intel now has nearly $12 billion of cash and equivalents, and only a little more than $1 billion in short- and long-term debt. That gives it a cash-to-debt ratio of over 11, which is a solid result and a slight increase over the year-ago figure. Quite simply, Intel's business continues to throw off significant cash.

Flow Ratio of Less Than 1.25 -- Intel continues to show improvement in this area as its flowie fell to 0.97. That's down from 1.19 year ago and 1.18 last quarter. A look at the balance sheet tells us this improvement was achieved through improved collection of accounts receivable, which was down 4% from the same quarter a year ago. Days sales outstanding (DSO) declined from 52 days to 45. Another positive was that inventory increased only 3% from a year ago. During the call, Intel did say that it would like to see its inventory level increase a little from where it presently stands. All told, however, the declining flow ratio tells us that Intel's working capital management is getting ever more efficient. That means more cash in the bank -- and we love that.

Intel also offered some news that relates to one of the more subjective Rule Maker criteria -- expanding possibilities. Intel's next generation chips are still on schedule for release in the second half of 2000. According to Paul Otellini, executive vice president of the Architecture Business Group, Intel is pleased with its first Itanium (formerly code-named Merced) silicon. Itanium is currently being sampled by original equipment manufacturers (OEMs) on Win64, IBM Monterrey, Linux, and HP Unix systems.

In addition, Intel is pleased with the launch of Intel Online Services, which offers Web hosting. So far, two facilities are open and Intel is signing up customers at an impressive pace. The early success of this business has exceeded Intel's expectations.

Finally, there were some comments during the call related to Taiwan and the recent earthquake there. While chipset supplies are in tight demand, all of Intel's Taiwan suppliers are meeting commitments for product. There has been some increase in DRAM prices and graphics chips, but Intel is not yet sure of the cause for these increases.

For investors focusing on the long term, I don't see anything that's particularly troubling about the quarter's results. This also marks the third straight quarter in which Intel's results have exceeded those of the same quarter a year ago. The financial statements indicate that Intel is running its business even more efficiently. Meanwhile, the most meaningful competitor, Advanced Micro Devices(NYSE: AMD), is sinking in red ink.